No Market, No Problem

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Use your own judgment. Seriously. That was the message from regulators as they scrambled to address allegations that fair-value accounting caused the credit crisis by forcing banks to overdiscount mortgage-related assets.

In early October, the Financial Accounting Standards Board and the Securities and Exchange Commission issued a joint reminder that companies with illiquid financial assets are allowed to use management assumptions — including cash-flow projections — in their fair-value analysis, rather than relying only on the last-available prices. FASB then fast-tracked an amendment to FAS 157 that included an illustration of how to value a collateralized debt obligation (CDO) minus active markets.

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The clarification “focuses people’s attention on the same thing that has always been in [FAS] 157 but may have been missed in practice: fair value requires judgment,” says David Larsen, a managing director for financial advisory firm Duff & Phelps.

That focus would seemingly allow companies to “severely discount” data from broken markets, and more easily justify a Level 3 analysis based on internal models, says Xerox chief accounting officer Gary Kabureck. These days, that should lead to higher asset values. In FASB’s example, the hypothetical firm could report an implied return of 22 percent on the CDO, despite the last market price implying a 15 percent return. However, some, including the American Bankers Association, would like a pass to fully ignore prices from broken markets.

The SEC must still complete, by January 2, a study on the effects of fair value. Will that lead to significant changes? Stay tuned.